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October 1, 2013

Forget Government Shutdown, Bigger Crisis Looms, Axel Merk Says

Interest expense could bankrupt the country in not-too-distant future

“Forget about a government shutdown. The quibbling over concessions to keep the government funded distracts from what might be the most predictable economic crisis.”

So argues currency manager Axel Merk, noting that the country faces problems that may affect everything from the value of the dollar to investors’ savings and even national security.

“To see why we have a problem, let’s look at the projections of the Congressional Budget Office,” Merk begins in his October insight. “From 1973-2012, government spending averaged 20.4% of GDP; in contrast government revenue averaged 17.4% of GDP. That equates to an average yearly deficit of 3%. As long as an economy grows sufficiently, it may be able to carry a sustained 3% annual deficit.”

Financing any level of government spending can occur either through increasing revenue (taxes) or borrowing. Trouble is that there aren’t enough “rich folks out there” to tax to mend the system, he argues.

He then lists the following projection by the CBO:

•In 10 years, our annual budget deficit is projected to be 4.5% of GDP.

•In 25 years, our annual budget deficit is projected to be 13.6% of GDP.

•In 35 years, our annual budget deficit is projected to be 18.7% of GDP.

But the biggest “elephant in the room,” he says, is interest expense. According to the CBO, in 2048, we will be spending almost 12% of GDP on interest expense, compared to just over 1% now. Differently said, as a share of GDP, we will be paying more in 2048 for entitlements and interest expense than we currently pay for all government services combined.

“Said still another way, even with substantially higher taxes, there may not be any money to pay for the military, education or infrastructure. In fact, Republicans and Democrats can stop arguing about discretionary spending, as there might not be any to fight over! [Erskine] Bowles argues, and we agree, that our deficits might be the biggest threat to our national security.”

So what does it mean for investors, he asks? The most obvious choice might be to consider shorting bonds. But while he agrees that bonds may be one of the worst investments over the coming decades, he warns that it can be very expensive to short bonds.

“Markets tend to exert maximum pain on investors; as such, it’s conceivable that bonds hold on much longer than one might think, possibly even rise. During this ‘wait and see’ period, investors shorting bonds have to pay the interest on them.”

A more effective way to prepare for what lies ahead might be to focus on the greenback, he concludes. The United States has a current account deficit. That means foreigners have to buy dollar denominated assets to keep the dollar from falling to cover the deficits. Higher interest rates might attract investors, but if one believes the Federal Reserve might keep rates artificially low, it also means that Treasury securities would be intentionally overpriced.